I.          BACKGROUND.  The Dodd-Frank Wall Street Reform and Consumer Protection Act¹ (the “Dodd-Frank Act”) repeals, effective July 21, 2011, Section 203(b)(3) (the “Repealed Private Adviser Exemption”) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) and increases state responsibility for oversight of investment advisers by increasing from $25 million to $100 million the dollar amount of assets under management that an investment adviser generally must have before it may register with the Securities and Exchange Commission (the “SEC”). Prior to the Dodd-Frank Act, Section 203(b)(3) was the broad federal investment adviser registration exemption that generally has been relied upon by private fund advisers.  Under this provision, an adviser that (i) had less than 15 clients in the preceding 12 months, (ii) did not hold itself out to the public as an investment adviser, and (iii) did not act as an adviser to a registered investment company or a company that had elected to be a business development company was exempt from registration under the Advisers Act.  Since each fund typically counted as a single client, this exemption allowed private fund advisers to manage an unlimited amount of assets and to advise up to 14 different private funds and other clients (e.g., managed accounts) without subjecting the adviser to federal investment adviser registration, examination by the SEC or the Advisers Act’s reporting or recordkeeping requirements.

Although this exemption disappears on July 21, 2011, the Dodd-Frank Act added new Section 203(m) to the Advisers Act which directs the SEC to provide a more limited federal registration exemption to any investment adviser that solely advises private funds if the adviser has assets under management in the United States of less than $150 million (the “Private Fund Adviser Exemption”).  Section 203(m) of the Advisers Act also directs the SEC to require investment advisers that qualify for the Private Fund Adviser Exemption to maintain such records and provide the SEC such annual or other reports as the SEC “determines necessary or appropriate in the public interest or for the protection of investors.”  On June 22, 2011, the SEC adopted Advisers Act Rule 203(m)-1², the final rule which implements the Private Fund Adviser Exemption.³  On the same date, the SEC also adopted Advisers Act Rule 204-4⁴ in order to implement the reporting requirement of Section 203(m) of the Advisers Act.⁵   Since advisers that qualify for the Private Fund Adviser Exemption will generally be subject to SEC reporting requirements, these advisers will fall into a newly created category of advisers known as “exempt reporting advisers.”⁶  In response to an inquiry made by our firm, the SEC’s Office of Investment Adviser Registration confirmed, however, that an adviser that advises only qualifying private funds that, in the aggregate, have less than $25 million in regulatory assets under management will not be subject to the reporting requirements applicable to exempt reporting advisers.

In SEC Release No. IA-3221 (the “Implementing Release”), the SEC also adopted numerous changes to Form ADV and rules implementing Section 410 of the Dodd-Frank Act, the statutory provision that generally increases the assets under management threshold for federal investment adviser registration from $25 million to $100 million.  This shift in state and federal responsibilities means that oversight of mid-sized investment advisers (i.e., those with between $25 million and $100 million in assets under management) will generally be reallocated from the SEC to the states, subject, however, to some notable exceptions described in Part IV of this memorandum.   Oversight of small investment advisers (i.e., those with less than $25 million in assets under management) will remain primarily with the states and oversight of large investment advisers (i.e., those with more $100 million or more in assets under management) will remain primarily with the SEC.  Many mid-sized investment advisers that are currently registered with the SEC will be required to switch to state registration within the deadlines prescribed by the SEC in the Implementing Release but, as explained in Part IV of this memorandum, other mid-sized advisers will be required to register or remain registered with the SEC.

This memorandum provides an overview of these important legal changes.  Part II of this memorandum summarizes the newly adopted Private Fund Adviser Exemption.  Part III of this memorandum describes the SEC reporting obligations of advisers that qualify for this exemption.  Finally, Part IV of this memorandum outlines the reallocation of federal and state oversight of investment advisers.  Part IV of this memorandum also describes some of the major changes that SEC has made to Form ADV, including requiring all advisers to disclose more information about the private funds they manage.   

If you would like additional information about anything discussed in this memorandum, please contact Geraldine Cunningham (GCunningham@kmollp.com; 212-906-8310).    

II.        THE PRIVATE FUND ADVISER EXEMPTION. 

A.        Executive Summary of the Private Fund Adviser Exemption.  The Private Fund Adviser Exemption, as applied to investment advisers that have their principal office and place of business in the United States⁷, generally exempts from the registration requirements of the Advisers Act an adviser that: (i) acts solely as an investment adviser to one or more qualifying private funds, and (ii) manages private fund assets of less than $150 million.  Thus, if a private fund adviser relying on this exemption accepts a client that is anything other than a qualifying private fund, such as a managed account, the adviser will immediately lose the exemption and must register with the SEC before accepting such a client. The term “qualifying private funds” is not limited to 3(c)(1) and 3(c)(7) funds⁸, as originally proposed⁹, and includes any private fund that is not registered under section 8 of the Investment Company Act of 1940, as amended (the “Investment Company Act”) and has not elected to be treated as a business development corporation under that act.  As a result, an investment adviser may treat as a private fund, any fund that qualifies for an exclusion from the definition of investment company under the Investment Company Act, in addition to the section 3(c)(1) and 3(c)(7) exclusions, provided that the adviser treats the fund as a private fund under the Advisers Act and its rules (e.g., complies with the reporting obligations of exempt reporting advisers).  

To determine its eligibility for the Private Fund Adviser Exemption, a private fund adviser must annually calculate its assets under management in accordance with calculation instructions provided on revised Form ADV and must annually report this calculation to the SEC via a partial Form ADV filing.¹⁰  An exempt private fund adviser that reaches the $150 million threshold generally will be given a 90-day grace period during which it may apply for SEC investment adviser registration.  However, an exempt private fund adviser that failed to comply with any of its SEC reporting requirements will not have the benefit of this grace period and must become SEC registered before meeting the $150 million threshold.   Private fund advisers that are “operationally integrated” with one or more advisory affiliates will likely be precluded from relying upon the Private Fund Adviser Exemption.  Specifically, the SEC has stated that, for purposes of determining eligibility for the Private Fund Adviser Exemption,  it will integrate and treat advisory affiliates that are “operationally integrated” as a single adviser.  As a result, private fund advisers that have advisory affiliates with whom they share management and other personnel and investment information and decision-making will likely be unable to rely upon the Private Fund Adviser Exemption.  

Advisers that relied upon the Repealed Private Adviser Exemption and do not qualify for the new Private Fund Adviser Exemption  may delay registering with the SEC and coming into compliance with the Advisers Act until March 30, 2012.  To ensure meeting this deadline, advisers that must register should file their registration applications no later than February 14, 2012.  Even if an adviser qualifies for the Private Fund Adviser Exemption, it may still need to register as an investment adviser with one or more states.  Thus, state law analysis is also important to ensure complete regulatory compliance.  Finally, the Private Fund Adviser Exemption is not mandatory.   Any adviser that qualifies for the exemption may elect to register (or remain registered) with the SEC, subject to the SEC registration prohibition set forth in Section 203A of the Advisers Act which prohibits SEC registration by small advisers (i.e., those with less than $25 million in assets under management) and, effective July 21, 2011, also will prohibit most mid-sized advisers (i.e., those with between $25 million and $100 million in assets under management) from registering with the SEC.

B.        The Private Fund Client Requirement.  Unlike the Repealed Private Adviser Exemption, the Private Fund Adviser Exemption imposes no cap on the number of funds advised by a private fund adviser.  While counting the number of clients advised is no longer necessary, assessing the type of clients advised is of paramount importance.  An investment adviser will not qualify for the Private Fund Adviser Exemption if the adviser accepts a single client that is not a “qualifying private fund.”  For example, advising a managed account would make an adviser ineligible for the Private Fund Adviser Exemption and, the SEC, in the corresponding adopting release, warned against converting separately managed accounts into single investor funds in order to avoid Advisers Act registration.  It is important to note that a private fund adviser that accepts a client that is not a qualifying private fund would immediately lose the Private Fund Adviser Exemption.  Therefore, the adviser should apply for and obtain SEC registration before it accepts a client that is not a qualifying private fund. 

The final rule somewhat expands what constitutes a “qualifying private fund” from what was originally proposed by the SEC.  As proposed, the Private Fund Adviser Exemption would have been available only to advisers of 3(c)(1) and 3(c)(7) funds.  However, in response to comments, the SEC defined a “qualifying private fund” to mean any private fund that is not registered under section 8 of the Investment Company Act and has not elected to be treated as a business development corporation under that act.  Under this definition, real estate funds, for example, and other funds that rely on exclusions from the definition of “investment company” under Section 3 of the Investment Company Act in addition to an exclusion provided by section 3(c)(1) or 3(c)(7) of the Investment Company Act, may also be treated as a private fund for purposes of the Private Fund Adviser Exemption.  However, to qualify for the Private Fund Adviser Exemption, advisers to qualifying private funds must meet all of the rule’s other conditions and must treat the fund as a private fund under the Advisers Act and its rules.  As a result, advisers who rely on this exemption must comply with the SEC’s newly adopted Form ADV reporting requirements applicable to exempt reporting advisers which are discussed below in Part III. 

C.        Calculating Regulatory Assets Under Management.  To determine eligibility for the Private Fund Adviser Exemption, a private fund adviser must annually aggregate the value of all its private fund assets to assess whether these asset values fall below the $150 million threshold.  Newly amended Form ADV instructs private fund advisers how to calculate the value of their “regulatory assets under management,” a term coined by the SEC to denote assets under management that must be calculated in accordance with Form ADV’s calculation instructions (e.g., the Private Fund Adviser Exemption threshold and the $100 million threshold dividing federal and state oversight of advisers).   Regulatory assets under management include the securities portfolios for which the adviser provides continuous and regular supervisory or management services as of the date of the Form ADV filing.  An account is a securities portfolio if at least half of the total value of the account consists of securities, cash  and cash equivalents.  Proprietary assets, assets managed without compensation, accounts of clients who are not United States persons, and uncalled capital commitments all must be included in the calculation.  For purposes of calculating regulatory assets under management, all of the assets of a 3(c)(1) or 3(c)(7) fund should be treated as a securities portfolio regardless of the nature of such assets.  If an adviser (e.g., a subadviser) provides continuous and regular supervisory or management services for only a portion of a securities portfolio, such adviser should include as regulatory assets under management only that portion of the securities portfolio for which it provides such services.  

An adviser must determine the amount of its private fund assets based on the market value of those assets, or fair value of those assets where market value is unavailable.  In addition, assets must be calculated on a gross basis, without deducting liabilities, such as accrued fees and expenses or the amount of any borrowing.  The SEC expects fair value calculations to generally be made in accordance with GAAP or another  international accounting standard but will permit advisers acting consistently and in good faith to use a different fair valuation standard.  Advisers that calculate fair value in accordance with GAAP or another basis of accounting for financial reporting purposes must also use that same basis for calculating their regulatory assets under management.  The SEC noted that the fair valuation process need not be the result of a particular mandated procedure and the procedure need not involve the use of a third-party pricing service or appraiser.  The SEC will permit the fair value procedure to follow what is outlined in the fund’s governing documents (e.g., the fund’s documents may provide that the fund’s general partner will determine the fair value of the fund’s assets).  Subject to a limited exception, advisers must also determine the fair value of real estates assets held by their private funds.  According to the SEC, this fair value requirement will not apply only in those limited circumstances where real estate assets are not required to be fair valued for financial reporting purposes under accounting principles that otherwise require fair value for assets of private funds.  In such cases, the adviser could, for example, value the real estate assets as the fund does for financial reporting purposes.  This limited exception to the fair valuation of real property, however, is not applicable if the adviser follows GAAP or another accounting standard that requires or in the future requires real estate assets to be fair valued.

All private fund assets of an adviser with a principal office and place of business in the United States¹¹ are considered to be “assets under management in the United States” for purposes of Section 203(m) of the Advisers Act and thus must be counted.  Although this memorandum does not provide a detailed discussion of the Private Fund Adviser Exemption’s application to non-U.S. advisers, a non-U.S. adviser need only count private fund assets it manages at a place of business in the United States toward the exemption’s $150 million threshold.  Non-U.S. advisers relying on the Private Fund Adviser Exemption, however, also will be subject to the reporting requirements applicable to exempt reporting advisers and to the anti-fraud provisions of the Adviser’s Act.

D.        Frequency and Timing of the Assets Under Management Calculation.  An Adviser relying on the Private Fund Adviser Exemption must calculate its regulatory assets under management once per year and report this amount in an annual updating Form ADV amendment¹² which must be filed within 90 days after the end of the adviser’s fiscal year.  The adviser’s calculation of its regulatory assets under management must be made within 90 days before the date of the adviser’s Form ADV amendment filing.   The requirement to calculate regulatory assets under management once annually, as opposed to quarterly calculations as originally proposed by the SEC, means fluctuations in the value of a private fund’s assets between annual updating amendments will not affect the availability of the exemption.  As noted in footnote 10 above, advisers that qualify for the Private Fund Adviser Exemption and manage less than $25 million in regulatory assets under management, will not be subject to the reporting requirements of exempt reporting advisers.

E.         The Effect of Reaching the $150 Million Threshold.  Unless another Advisers Act registration exemption is available, a private fund adviser that reports in its annual updating Form ADV amendment that it has at least $150 million of regulatory assets under management will no longer qualify for the Private Fund Adviser Exemption.  If the private fund adviser has complied with all of its reporting obligations described in Part III below, the Adviser will have the benefit of a 90-day grace period in which to apply for SEC investment adviser registration.  During this transition or grace period, the private fund adviser may continue acting as a private fund adviser but must continue complying with all of the other terms of the Private Fund Adviser Exemption (e.g., before the effectiveness of the adviser’s registration with the SEC, the adviser could not accept a client that was not a private fund and the adviser must continue to fulfill the reporting obligations of an exempt reporting adviser).   Emphasizing the importance of strict compliance with the reporting obligations of an exempt reporting adviser, the SEC has made the 90-day grace period unavailable to private fund advisers that do not comply with all of their SEC reporting requirements.  Such a non-compliant adviser, therefore, must be approved as an SEC registered investment adviser before reaching the $150 million threshold unless the adviser qualifies for some other registration exemption.   Advisers switching from exempt reporting adviser status to SEC registered adviser status will use a single filing to submit a final report as an exempt reporting adviser and to apply for SEC registration.

F.         The Exemption’s Applicability to Subadvisers and Private Fund Advisers with Advisory Affiliates.

Although the client of a subadviser is generally the private fund’s primary adviser, rather than the fund itself, the SEC permits subadvisers to rely on the Private Fund Adviser Exemption if the subadviser’s services to the primary adviser relate solely to private funds and the subadviser satisfies all of the other conditions of the exemption. 

In its proposal of the Private Fund Adviser Exemption, the SEC anticipated that a private fund adviser with advisory affiliates would encounter interpretative issues as to whether the private fund adviser could rely on the exemption without taking into account the activities of its affiliates.  The SEC requested comment on whether the final rule should compel an adviser to take into account the activities of its advisory affiliates when determining its eligibility for the Private Fund Adviser Exemption, by having the rule, for example, specify that the exemption is not available to an affiliate of a registered investment adviser.  Commenters favored the separate treatment of advisory affiliates but the SEC believes that this approach would permit improper structuring to qualify for the exemption.  For example, the SEC noted that if integration of affiliated advisers was not required, an adviser managing $200 million in private fund assets could establish two separate advisers that each qualify for the Private Fund Adviser Exemption.  Given these concerns, the SEC has stated that it will integrate, or treat as a single adviser, two or more affiliated advisers that are separate entities but are operationally integrated and that this treatment could require the registration of one or both of the advisers (e.g., if one of the advisers has non-private fund clients or, when integrated, the regulatory assets under management of the advisers equal or exceed $150 million).

Whether advisory affiliates should be deemed integrated will depend on the particular facts and circumstances.   The SEC noted that the following factors should be taken into account when making an integration determination:  (1) is the private fund adviser adequately capitalized, (2) does the private fund adviser have a buffer between its personnel and the personnel of the affiliate (e.g., are a majority of the members of the board of directors of the private fund adviser independent of its advisory affiliate), (3) are the employees, officers and directors  of the private fund adviser, who if engaged in providing advice in the day-to-day business of the adviser, not otherwise engaged in the investment advisory business of the advisory affiliate, (4) does the private fund adviser itself make the decisions as to what investment advice will be communicated to, will be used on behalf of, its clients and does it have and use sources of investment information not limited to its advisory affiliate, and (5) does the private fund adviser keep its advice confidential until communicated to its clients.  As a result of this interpretation, many private fund advisers that have advisory affiliates with whom they share management and other personnel and investment information and decision-making will be unable to rely upon the Private Fund Adviser Exemption.

G.        State Law Registration Considerations.  It is important to keep in mind that an adviser that qualifies for the Private Fund Adviser Exemption may still need to register as an investment adviser with one or more state securities authorities.  Currently, the states are reacting legislatively to the new Dodd-Frank Act rules.  Connecticut, for example, under the pre-Dodd-Frank regulatory regime, has not required the registration of advisers that had assets under management of at least $25 million and were not required to register with the SEC as a result of the Advisers Act Section 203(b)(3) exemption¹³.  As previously noted, the 203(b)(3) exemption will disappear on July 21, 2011, and, as a result, Connecticut’s piggy-back exemption will also disappear.  On July 11, 2011, Connecticut adopted an order, effective July 21, 2011, that exempts an adviser that qualifies for the Private Fund Adviser Exemption from the Connecticut investment adviser registration requirements, provided that the adviser submits to the Connecticut Banking Commissioner the Form ADV reports the SEC requires from exempt reporting advisers, neither the adviser nor any of it is supervised persons or control persons is subject to certain administrative, civil or criminal sanctions, and the adviser is in compliance with all SEC rules promulgated under the new SEC Private Fund Adviser Exemption. Connecticut’s Banking Commissioner also adopted an order that delays, until March 30, 2012, the state registration deadline for advisers that relied upon the Repealed Private Adviser Exemption and, as a result of Dodd-Frank, are ineligible to register with the SEC and must register with Connecticut.  Additionally, advisers that relied upon the Repealed Private Adviser Exemption and, as a result of Dodd-Frank, must register with the SEC and submit a notice filing to Connecticut, will have until March 30, 2012 to file the required notice.    As was the case pre-Dodd-Frank, New York has a de minimis exemption that excludes from the definition of “investment adviser” a person who sells investment advisory services to fewer than six persons resident in New York (excluding certain institutions) and generally allows a private fund to be counted as one person.  New York based private fund advisers can continue to rely upon this exemption, absent its repeal or revision.

H.        Compliance Dates.  Rule 203(m)-1, the Private Fund Adviser Exemption, becomes effective on July 21, 2011.  However, advisers who were exempt under the Repealed Private Fund Exemption and now need to register with the SEC will have until March 30, 2012 to become SEC registered and to become compliant with the various  requirements of the Advisers Act.  Because investment adviser registration applications can take up to 45 days to be approved, advisers that need to register should file their registration application by no later than February 14, 2012.  Advisers who qualify for the Private Fund Adviser Exemption and are subject to the reporting requirements of exempt reporting advisers will need to submit their first reports on Form ADV via the Investment Adviser Registration Depository (“IARD”) system between January 1, 2012 and March 30, 2012.

III.       REPORTING REQUIREMENTS OF EXEMPT REPORTING ADVISERS AND INCREASED FORM ADV PRIVATE FUND DISCLOSURES.

A.        Executive Summary of the Reporting Requirements.  To reflect the reporting obligations of exempt reporting advisers, Form ADV will serve as a reporting form for these advisers as well as a registration form for advisers required to register with the SEC or a state.  Exempt reporting advisers will be required to file and update a limited subset of Form ADV, Part 1 items and these reports will be publicly available.  Initial reports from exempt reporting advisers will be due within 60 days of relying on the applicable registration exemption (e.g., the Private Fund Adviser Exemption).  However, because the IARD system is being re-programmed to accept Form ADV, as amended by the Dodd-Frank changes, exempt reporting advisers must file their initial Form ADV reports between January 1, 2012 and March 30, 2012.  As noted in footnote 10, however, advisers that qualify for the Private Fund Adviser Exemption and manage less than $25 million in regulatory assets under management, will not be subject to the reporting requirements of exempt reporting advisers.  Exempt reporting advisers will also be subject to SEC mandated recordkeeping requirements that will the subject of a future SEC release.  It is also important to remember that, although exempt from federal registration, exempt reporting advisers may be subject to state registration, reporting, or other obligations.  Thus, exempt reporting advisers must also consider applicable state law requirements, and, if required to register with a state, will be required to file a complete Form ADV.  Form ADV has been amended significantly to require greater disclosure from both registered advisers and exempt reporting advisers, including increased disclosure about the private funds managed by these advisers.

B.        What Must Exempt Reporting Advisers File.

        1.         The Initial Report.  Advisers that qualify for the Private Fund Adviser Exemption must nevertheless report to the SEC by submitting to the SEC, and periodically updating, a subset of Form ADV items.  Accordingly, Form ADV will serve as both a registration and reporting form.  Exempt reporting advisers will not be required to file Part 2 of Form ADV (the “brochure”) but will be required to complete the following seven items of Part 1 of revised Form ADV:

• Item 1 (Identifying Information);
• Item 2.B (SEC Reporting by Exempt Reporting Advisers) (i.e., identifying the registration exemption upon which the exempt reporting adviser relies, namely, the Private Fund Adviser Exemption or the venture capital fund adviser exemption);
• Item 3 (Form of Organization);
• Item 6 (Other Business Activities);
• Item 7 (Financial Industry Affiliations and Private Fund Reporting) (see also paragraph E of this Part III for more detail regarding private fund reporting);
• Item 10 (Control Persons); and
• Item 11 (Disclosure / Disciplinary Information).

Information reported by exempt reporting advisers will be publicly available on the internet via the Investment Adviser Public Disclosure System at www.adviserinfo.sec.gov., in part, to allow investors to check the reporting information against the disclosure documents they received directly from the adviser.

        2.         Required Updates to Reports.  Pursuant to amended rule 204-1 under the Advisers Act¹⁴, exempt reporting advisers will be subject to the same Form ADV updating requirements applicable to SEC registered advisers.  As a result, an exempt reporting adviser will be required to amend its Form ADV report at least once per year within 90 days after the end of the adviser’s fiscal year, and more frequently, as required by the instructions to Form ADV (i.e., updates required promptly if Items 1 (Identification Information, 3 (Form of Organization) or 11 (Disciplinary Information) become inaccurate in any way, or if information in item 10 (Control Persons) becomes materially inaccurate).

        3.         Final Reports.  In order for the SEC to distinguish between exempt reporting advisers that are no longer subject to reporting requirements and those that are not complying with their reporting obligations, exempt reporting advisers must file a final report if they cease business or are registering with the SEC because the adviser has chosen to register or no longer qualifies as an exempt reporting adviser.¹⁵  An exempt reporting adviser that is registering with the SEC may file a single amendment to its Form ADV that will serve both as a final report of an exempt reporting adviser and an application for SEC investment adviser registration.  An adviser switching from exempt reporting adviser status to SEC registered adviser status must continue to comply with the terms of the exempt reporting adviser exemption upon which it relies (e.g., the Private Fund Adviser Exemption) until the adviser’s SEC registration becomes effective.  For example, an exempt reporting adviser that relied upon the Private Fund Adviser Exemption may not accept a non-private fund client before the adviser’s SEC registration is effective and, pending registration, must continue to comply with exempt reporting advisers’ reporting obligations.

An adviser that relied upon the Private Fund Adviser Exemption and is registering with the SEC because the adviser has met or exceeded the $150 million threshold, will generally have 90 days from filing its annual updating amendment to apply for SEC registration.  However, if such an exempt reporting adviser did not comply with all of its reporting obligations, this grace period will be unavailable.  Therefore, unless another registration exemption applies, such a non-compliant adviser must become SEC registered before reaching the $150 million threshold.

An adviser may not be simultaneously registered with the SEC and filing as an exempt reporting adviser.  An adviser registered with the SEC and switching to exempt reporting adviser status must withdraw its registration, via Form ADV-W, before submitting its first exempt reporting adviser report. 

C.        Reporting Deadlines for  Exempt Reporting Advisers.   Exempt reporting advisers will be required to file their initial Form ADV report with the SEC within 60 days of relying on the Private Fund Adviser Exemption or the venture capital fund adviser exemption, as the case may be.  However, because the IARD system is currently being re-programmed to accept Form ADV, as amended by the Dodd-Frank Act’s implementation, no exempt reporting adviser can file its initial report before January 1, 2012.  Accordingly, the SEC is requiring exempt reporting advisers to file their initial Form ADV reports between January 1, 2012 and March 30, 2012.

D.        Filing Fees and SEC Examinations of Exempt Reporting Advisers.  The SEC has not yet determined the filing fees that will apply to reports filed by exempt reporting advisers.  The SEC anticipates that these fees will range from $40 to $225 based upon the amount of the filer’s regulatory assets under management.  The General Instructions to Form ADV provide that filing fees are inapplicable to other-than-annual amendments, final reports of exempt reporting advisers, and Form ADV-W.  While the SEC may conduct examinations of exempt reporting advisers, the SEC stated in the Implementing Release that it does not expect to conduct compliance examinations of this category of advisers unless there is some indication of wrongdoing.

E.        Increased Private Fund Disclosures Required by Registered Advisers and Exempt Reporting Advisers and Other Form ADV Amendments.

        1.         Increased Form ADV Disclosure Generally.  In addition to Form ADV amendments made to reflect the new Dodd-Frank exemptions from registration and to reflect the increased threshold for SEC registration, the SEC has amended Form ADV to elicit more information about:

                        a.          private funds advised by registered advisers or exempt reporting advisers (including information about the size and organization, operation, and investment characteristics of each private fund, as well as information about certain service providers to each fund);

                        b.         the adviser’s business (including data about types of clients,  employees of the adviser and their advisory activities, and business practices that may present significant conflicts of interest, such as the use of affiliated brokers, soft dollar arrangements (i.e., disclosing whether all soft dollar benefits received qualify for the safe harbor under Section 28(e) of the Exchange Act for eligible research or brokerage services), and compensation for client referrals (i.e., disclosing whether the adviser or any of its related persons receives direct or indirect compensation for client referrals);

                        c.         the adviser’s non-advisory activities and financial industry affiliations; and

                        d.         the adviser’s chief compliance officer (i.e., requiring contact information for the adviser’s chief compliance officer or another person authorized to receive information and respond to questions about the adviser’s Form ADV; please note that this contact information will not be publicly available). 

        2.         Increased Private Fund Reporting.  Amended Form ADV will require all advisers, including exempt reporting advisers, to provide more information about each “private fund” advised by the adviser.  A private fund is an issuer that would be an investment company, as defined in the Investment company Act of 1940, but for Section 3(c)(1) or 3(c)(7) of that Act.  In addition, if a private fund has issued two or more series (or classes) of equity interests whose values are determined with respect to separate portfolios of securities and other assets, then each such series (or class) must be regarded as a separate private fund for Form ADV purposes.

                        Basic information regarding the size, organization, operation, investment characteristics and service providers of each private fund must now be disclosed by advisers.  An adviser need not, however, provide this information with respect to private funds advised by a related person of the adviser.¹⁶  For each private fund advised by the adviser, revised Form ADV will require the adviser to disclose, among other things:

                        a.         the Investment Company Act exemption upon which the fund relies;

                         b.        whether the fund is a fund of funds or a master-feeder fund;

                         c.        fund type (i.e., hedge fund, liquidity fund, private equity fund, real estate fund, securitized asset fund, venture capital fund, or some other type of private fund);

                         d.        the current gross asset value of the private fund;

                         e.        the minimum investment commitment required of investors;

                         f.         the approximate number of the fund’s beneficial owners and the approximate percentage of beneficial owners that are related persons of the fund, fund of funds, and non-U.S. persons;

                         g.        whether a sub-adviser also advises the fund;

                         h.        whether the adviser’s clients are solicited to invest in the fund, and if yes, the approximate percentage of the adviser’s clients that have invested in the fund;

                         i.         whether the private fund relies on an exemption from registration of its securities under Regulation D of the Securities Act of 1933, and if yes, the fund’s Form D SEC file number must be provided; and

                         j.         information regarding the fund’s auditors, prime broker, custodian, administrator and marketers.¹⁷ 

To avoid multiple reporting about the same private funds where there are multiple advisers to a private fund (e.g., primary adviser and sub-adviser), only one adviser must report the full scope of information for the fund.  The other adviser to the fund need only identify the applicable fund, identify the adviser that is reporting full information about the fund, and disclose whether the adviser’s clients are solicited to invest in the private fund. Advisers to master-feeder funds will be permitted to submit one response for the master fund and all of the feeder funds if these funds would otherwise report substantially identical information.  Form ADV will require a unique identification number for each private fund for which Form ADV disclosure is required.  Thus, private fund advisers (both registered and exempt reporting) must obtain these identification numbers via the IARD website before their next Form ADV filing.

IV.  REALLOCATION OF FEDERAL AND STATE OVERSIGHT OF INVESTMENT ADVISERS.   

A.        Executive Summary of the Reallocation.  Subject to the $20 million mandatory SEC registration and de-registration buffer (described in Part IV.C below) that the SEC has created for mid-sized advisers with close to $100 million in regulatory assets under management, the post Dodd-Frank division of investment adviser oversight between the SEC and the states can be briefly summarized as follows: 

                        (a)        small advisers (i.e., advisers that have less than $25 million in regulatory assets under management) are generally prohibited from SEC registration, but, if eligible, these advisers may take advantage of certain exemptions from the SEC registration prohibition on small advisers (see footnote 22) and may register with the SEC if the small adviser advises a registered investment company;

                        (b)       mid-sized advisers (i.e., advisers having between $25 million and $100 million in regulatory assets under management) that are not required to register as an investment adviser with the state in which the adviser maintains its principal office and place of business, or if required to register, are not subject to examination as an investment adviser, must register with the SEC unless they qualify for another Advisers Act registration exemption (e.g., the Private Fund Adviser Exemption); otherwise, mid-sized advisers are prohibited from SEC registration but may also take advantage of certain exemptions from the SEC registration prohibition on mid-sized advisers (see footnote 22) and may register with the SEC if the mid-sized adviser advises a registered investment company or a company which has elected to be a business development company;  and

                        (c)       large advisers (i.e., advisers that have regulatory assets under management of $100 million or more) will generally continue to register with the SEC unless they qualify for another Advisers Act registration exemption (e.g., the Private Fund Adviser Exemption may be available to large advisers with under $150 million in regulatory assets under management).

In order to determine which SEC registered advisers may remain registered with the SEC post Dodd-Frank, every investment adviser, regardless of size, that is registered with the SEC as of January 1, 2012 (or has a registration application pending as of that date) must determine whether it may remain SEC-registered¹⁸ and must file a Form ADV amendment by March 30, 2012.  Advisers no longer eligible for SEC registration must register in one or more states, as applicable, and withdraw their SEC registration no later than June 28, 2012. 

B.        General Discussion of the Federal / State Reallocation.  The Advisers Act requires all investment advisers to register with the SEC unless the adviser is prohibited from such registration under Section 203A of the Advisers Act or is exempt from such registration under section 203 of the Advisers Act (e.g., the Private Fund Adviser Exemption).  Prior to the Dodd-Frank Act, Section 203A of the Advisers Act prohibited investment advisers regulated by the state in which the adviser has its principal office and place of business and having less than $25 million in assets under management from registering with the SEC unless the adviser was an adviser to a registered investment company.  In this context, the SEC interprets “regulated” to mean simply that the applicable state had enacted an investment adviser statute, regardless of whether the adviser was in fact exempt from registration or excluded from the state’s definition of an “investment adviser.”  Currently, Wyoming is the only state that does not have an investment adviser statute.  Thus, all Wyoming-based investment advisers, including small advisers, must register with the SEC unless a federal registration exemption is available to them.  This “small adviser” prohibition remains unchanged by the Dodd-Frank Act. 

The Dodd-Frank Act expanded the Section 203A federal registration prohibition to generally include mid-sized investment advisers (i.e., advisers with between $25 million and $100 million in regulatory assets under management).  Mid-sized advisers, however, are not prohibited from registering with the SEC if the mid-sized adviser advises a registered investment company or a company which has elected to be a business development company or the mid-sized adviser would be required to register with 15 or more states.  In addition, unless another exemption from SEC registration is available (e.g., the Private Fund Adviser Exemption), mid-sized advisers that are not required to register as an investment adviser with the state in which the adviser maintains its principal office and place of business, or if required to register, are not subject to examination as an investment adviser, are not subject to this prohibition and must register with the SEC.   As a result of generally prohibiting mid-sized advisers from registering with the SEC and making the states primarily responsible for the oversight of these advisers, many mid-sized advisers currently registered with the SEC, will need to register with the applicable state authorities and withdraw their SEC registration.  In addition, mid-sized advisers must analyze their home state registration requirements in order to determine where they must register post-Dodd-Frank.      

Form ADV has been amended to require mid-sized advisers registering with the SEC to demonstrate the basis upon which their registration is permitted.  Specifically, a mid-sized adviser must affirm on its initial Form ADV (and thereafter on its annual Form ADV amendments) that the adviser either (a) is not required to register with the state¹⁹ securities authority in the state where it maintains its principal office and place of business²⁰; or (b) is not subject to examination as an adviser by that state.  According to the SEC and amended Form ADV, a mid-sized adviser is “not required to be registered” with its home state securities authority (and will be required to register with the SEC unless a registration exemption is available to the adviser) if the adviser is exempt from registration under the investment advisory laws of the state in which it has its principal office and place of business, or is excluded from the definition of investment adviser in that state.²¹   The SEC contacted the states directly to identify which states do not subject investment advisers to examination.  The three states that fall into this category are: New York, Montana, and Wyoming.  Thus, mid-sized advisers based in those states must register (or remain registered) with the SEC.  Additionally, as previously noted, since Wyoming does not regulate investment advisers, Wyoming-based small advisers generally must register (or remain registered) with the SEC.  If, in the future, a mid-sized investment adviser can no longer make the affirmations set forth in clauses (a) and (b) above, the adviser will have 180 days from its fiscal year end to withdraw its SEC registration.²²

C.        The $20 Million Buffer for Mandatory SEC Registration and Deregistration of Mid-Sized Advisers.  In order to prevent mid-sized advisers from having to frequently switch between state and SEC registration as a result of fluctuations in regulatory assets under management, the SEC is amending Advisers Act Rule 203A-1²³ to provide mid-sized advisers with a $20 million buffer with respect to mandatory SEC registration and de-registration.  As a result, a mid-sized adviser may register with the SEC (rather than with the applicable states) if the adviser has between $100 million and $110 million in regulatory assets under management and must register with the SEC if the adviser has at least $110 million in regulatory assets under management.²⁴  If a state registered adviser reports regulatory assets under management of $110 million or more on its annual Form ADV amendment, the adviser must register with the SEC within 90 days after its Form ADV amendment filing unless the adviser qualifies for an SEC registration exemption (e.g., the Private Fund Adviser Exemption).  Once registered with the SEC, an adviser need not withdraw its registration unless the adviser has less than $90 million in regulatory assets under management.  As additional protection from frequent registration switching, advisers will be required to assess their eligibility for SEC registration only once each year as part of their annual update to Form ADV.  The SEC is also giving advisers some additional flexibility by allowing the adviser to select the date as of which it calculates its regulatory assets under management for Form ADV reporting, provided the calculation is made within 90 days of the Form ADV filing date.  

D.        When and How to Switch from SEC to State Registration.  The transition to state registration for mid-sized advisers no longer eligible to remain SEC registered will be governed by new Advisers Act Rule 203A-5²⁵. In order to determine which SEC registered advisers may remain registered with the SEC, every investment adviser, regardless of size, that is registered with the SEC as of January 1, 2012 (or has a registration application pending as of that date) must file a Form ADV amendment by March 30, 2012 and report the adviser’s regulatory assets under management determined within 90 days of the filing.²⁶  Mid-sized advisers that are no longer eligible for SEC registration will be required to register in one or more states and withdraw their SEC registration by June 28, 2012.  Mid-sized advisers registered with the SEC as of July 21, 2011 that must switch to state registration, however, must remain registered with the SEC (unless an exemption from SEC registration is available) until after January 1, 2012 when the re-programming of the IARD should be completed.  Thus, the SEC has postponed the process of switching from SEC to state registration until 2012.    

Nevertheless, the SEC is encouraging advisers to consult state law for the states in which the adviser is doing business as soon as possible to determine if the adviser is subject to any registration requirements in those states and to begin the registration process.   Advisers switching to state registration are also encouraged to file with the applicable states as soon as possible so that the states can conditionally approve the registrations until the re-filing of Form ADV is completed.  After June 28, 2012, the SEC will cancel the registration of any adviser that is no longer eligible to be SEC registered and failed to file an amendment or withdraw their registration in accordance with new Rule 203A-5.  As of July 21, 2011, newly registering mid-sized advisers that are not eligible to register with the SEC as a result of Dodd-Frank, must register with the applicable state securities authorities.

If you would like additional information about anything discussed in this memorandum, please contact Geraldine Cunningham at GCunningham@kmollp.com (212-906-8310).

Disclaimer

This memorandum may be considered attorney marketing and/or advertising.  The information contained in this memorandum is for informational purposes only and is not intended and should not be considered legal advice on any subject matter.  Recipients of this memorandum should not act or refrain from acting on the basis of any information included in this memorandum without seeking appropriate legal or other professional advice.  This information is presented without any warranty or representation as to its accuracy or completeness, or whether it reflects the most current legal developments.

To ensure compliance with Treasury regulations regarding practice before the IRS, we inform you that, unless expressly stated otherwise, any federal tax advice contained in this communication was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding penalties that may be imposed on the taxpayer under United States federal tax law, or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.

©2011 Kavanagh Maloney & Osnato LLP, 415 Madison Avenue, New York, NY 10017, 212-207-8400, www.kmollp.com.  All rights reserved.